1. Keynes’ Beauty Contest: Speculative Price Bubbles in the Absence of Common Knowledge in Experimental Stock Markets
Shin’ichi Hirota and Shyam Sunder
2002 PC and ESA Meetings, March 23, 2002
Speculative Bubbles

2. The Purpose of Our Study
Test the validity of Keynes’ beauty contest story in experimental markets
Speculative Bubbles

3. John Maynard Keynes (1936)
Stock Market is like a newspaper beauty contest
Stock Price is determined not by investors' own beliefs,but by their beliefs about others’ beliefs
Speculative Bubbles

4. Beauty Contests I believe that I buy shares if P < 200, P=200
others believe that V = 200
I buy shares if P < 200,
expecting that I can resell them to others at 200.
P=200
even if every investor believes F=100
Speculative Bubbles

5. Bubbles are generated by
the gap between
the first order beliefs (F)
investors’ own beliefs
and
the second (higher) order beliefs (S)
investors’ beliefs about others’ beliefs
Speculative Bubbles

6. How to verify? Plausible story?
Well-known to practitioners and economists
Difficult to verify in the actual stock markets
The gap between F and S is not observable
Speculative Bubbles

7. In Laboratory Possible to open a gap between F and S
F: controllable
Give dividend value to subjects
S: controllable (in some extent)
By experimental design
Observe the consequences
Speculative Bubbles

8. 2 Types of Keynes’ Bubble
S= 200 (even if F =100), because
investors believe that others believe that …
F = [Type I]
A gap between 1st and 2nd order beliefs about fundamentals
others believe that V = [Type II]
Infinite sequence of higher order beliefs
This bubble occurs in infinite maturity securities
Speculative Bubbles

9. Experimental Markets
Double auction market for multiple units of a single security
15 trading periods (3 minutes each)
Each investor endowed with 10 shares, 10,000 points in “cash”
Only terminal dividends
Dividends is private information
The range of dividends is announced publicly
Speculative Bubbles

10. Experimental Design (1) Gap between F and S
A gap between F and S about fundamentals
Dividend Value (F)  Announced Dividend Range
F<S
Type I bubble may be observed
Speculative Bubbles

11. Experimental Design (2) Gap between F and S
Infinite maturity sessions
The number of periods is uncertain
Terminal payoff is determined by the price prediction for the next period (made by predictor).
Type II bubble may be observed
Speculative Bubbles

12. Gap between first (F) and second (S) order beliefs about fundamentals
4 Sessions
Maturity of the stock
Finite
Infinite
Gap between first (F) and second (S) order beliefs about fundamentals
F=S
Session 2
(Type II)
FS
Session 3
(Type I)
Session 1
(Type I & II)
Session 4
(No Bubble)
Speculative Bubbles

13. Trading Screen
Speculative Bubbles

14. Tentative Results Result 1: Result 2: Keynes is right!
Bubbles can form when there is a gap between 1st and 2nd order beliefs about fundamentals (Type I bubble).
Result 2:
Bubbles can form and persist through the end of a session when the security has infinite maturity.
The price is totally dependent on market expectations (Type II bubble).
Keynes is right!
Speculative Bubbles

15. More Sessions Session 5-7 (F  S about fundamentals)
No bubble observed
Doubt on Result 1
Session 8 (Infinite maturity session)
Bubble observed
Confirm Results 2
Speculative Bubbles